Contrary to the previously presented demand theories, life insurance markets in reality are incomplete. This section introduces two market imperfections of asymmetric information: adverse selection and contract non-performance as well as search and transactions costs. It further explains why these market imperfections might lead to partial micro life insurance coverage. For an overview, results are again summarized in Table 7 (p. 48). Even though, most of the presented models are developed in the context of non-life insurance, they are applicable to term life insurance as in both cases the purpose of insurance is to protect a specific loss by providing a lumpsum payment in
case of risk occurrence. The situation would be different, i.e. in the context of endowment insurance or private pensions because of the involved savings components or frequent annuity payments over an uncertain time span.
Informational asymmetries
In a typical life insurance market, the information available to the customer and insurer is incomplete. Usually, information of the two parties is distributed asymmetrically between the two. For example, insurers may not have sufficient information at hand to assess the risk to be insured. In most cases the consumer knows more about her living conditions and her personal health status, which both determine her risk profile. If her risk profile is high, she may opt for higher insurance coverage, known as adverse selection. On the other side, consumers do not know how the insurer performs financially over time or in case of a loss, and are therefore exposed to the risk of contract non-performance. The issue of moral hazard, where an insured person takes more risk after concluding an insurance contract, is not discussed in this setting, as in the context of micro life insurance it would mean that a person is willing to put her life at risk after taking out insurance, which is a rather unrealistic scenario.
Adverse selection
Literature on adverse selection tells that in the state of a separating equilibrium high- risk individuals are more likely to buy full insurance coverage at a higher premium whereas low risk individuals partially insure at a lower rate (Rothschild and Stiglitz, 1976). In their model for non-life insurance, Rothschild and Stiglitz assume full competition and two kinds of individuals: high risk and low risk consumers. If information asymmetries are present and insurance companies do not have sufficient knowledge about risk-profiles, they offer insurance services at an average premium with an expected profit of zero. However, an average premium attracts more high risk individuals knowing their risk profile. Insurance is relatively cheap for them than. Low risk consumers on the contrary will under purchase or buy no coverage at all. In a second scenario, the insurer could also offer separate insurance contracts for the low and high risk customers at actuarially fair premiums. If the insurer does not know which customer is of low or high risk, then all high-risk individuals will purchase the low risk insurance contract. In both cases and under full competition the insurer makes a profit
of zero with the low risk customers but losses with the high-risk customers, leading to a loss in profits or an increase in premium further reducing the number of low-risk profiles within a company’s customer base. Under these circumstances the insurer offers full coverage to high risk individuals at a premium which allows him to make no losses but zero profits with this market segment. While he offers only partial insurance at a premium rate which is on the one hand attractive to the low risk individuals but on the other hand still ensures that high risk customers prefer full coverage at a higher premium. Under adverse selection, low risk customer prefer lower insurance coverage at a lower premium rate whereas high risk individuals buy higher coverage at a higher premium (Rothschild and Stiglitz, 1976; Schlesinger, 1994), which also applies to term life insurance.
Contract non-performance
In the earlies nineties, the discussion started on how an incomplete information about the insurer impacts insurance consumption. On the supply side the insurer is more knowledgeable about her performance which poses a risk of contract non-performance for the customers. Based on the non-life insurance model of Mossin (1968), Doherty and Schlesinger (1990) analyzed how contract non-performance affects an individuals’ decision to purchase insurance. They consider the case where an insurance company might not perform on its contractual obligation due to insolvency, on-going disputes about eligibility of a claim payout, or heavy delay in claim settlements. Under the assumption of default risk, Doherty and Schlesinger show that previous theoretical results on insurance demand do not hold. In the case of default risk, it is optimal for an individual to buy less than full insurance coverage even if the premium is actuarially fair. In the context of term life insurance offered as microinsurance product, contract non-performance could be of great relevance, as consumer protection rights and complaints mechanisms are typically weak and the supervision of the insurance sector and legal enforcement is less developed compared to industrialized countries.
Search and transaction costs
Search and transaction costs (which may include money, time or any other effort) increase the indirect costs of insurance. If the effort to obtain information on insurance premiums is too high or the purchase of insurance involves travel costs to the nearest
agent, it might be more efficient for the individual to refrain from life insurance consumption and to self-insure instead. Under the presence of search or transaction costs an individual will only bear these costs and purchase insurance if the difference in expected utility with and without insurance is sufficiently large (Kunreuther et al., 2013: 70-71; Schlesinger and Doherty, 1985). In the context of term life micro insurance, these costs might be relatively large as potential customers are often not aware or knowledgeable about insurance, obtaining information may be time-consuming, and insurance services might not be accessible in their neighborhood.
This section summarized main explanations of demand behavior if markets are incomplete. If information is distributed asymmetrically between the insurer and the insured, full life insurance coverage is only attractive to a specific segment of the market, the high-risk individuals, whereas partial coverage is selected by low risk consumers. The risk of contract non-performance may turn life insurance to be perceived as unattractive by the low-income consumer. Search and transactions have been introduced as additional costs, further factors reducing the consumption of micro life insurance.
Overall, the last two sections of this chapter analyzed the decision to consume life insurance as an isolated choice of the household. The models presented so far did not consider other risk management strategies and their interdependence with life insurance consumption. This is the content of the following section.